Option Investor
Educational Article

The School of Hard Knocks Part 2

HAVING TROUBLE PRINTING?
Printer friendly version

The School of Hard Knocks Part 2
By David Popper

Many years ago, a young trial lawyer found himself in a case in which he was severely overmatched. On the night before his final argument, he was working feverishly. The harder he worked, the more confused he became, until the whole argument was one disjointed mess. He just knew that he would make a fool of himself. He just knew that word would get back to his boss and that he would be fired. Sure he was tired. Twenty hour days for two weeks straight is tiring. It also caused him to lose sight of the big picture. He could not see the forest from the trees. He was intimidated. After years of dreaming for the opportunity of being lead counsel in a huge trial, he was not relishing the challenge, instead, he was shrinking from it. Somewhere around 10:00 that evening, his boss came by to pick up a file. He observed the young attorney's demeanor and asked a few general questions about the case.

At 9:00 AM the next day, it was time to proceed. The young trial lawyer looked over his shoulder to see the size of the crowd. To his surprise, his boss was in the courtroom. Now his heart really raced. Then the older attorney stood, approached the table and asked, "May I argue this one?" Twenty minutes later the older attorney gave a stirring and passionate argument. After the case was over, the younger attorney was dumbfounded. "How in the world could you argue so well and so passionately on such little preparation," asked the young lawyer. "Little preparation, are you kidding," exclaimed the older gentleman. "Son, I have had thirty years of preparation and have suffered greatly. Thirty years of legal practice teaches you about yourself and others that you cannot learn out of a book. Son, you cannot argue passionately until you have suffered deeply. I have had thirty years generally and twenty minutes in direct reparation for this argument."

Last week, I discussed the impact of my first real initiation into a market correction. The dates were August 31st and September 1st, 1998. Before that time, I had read the books, read the newsletters, read IBD and followed the rules, but it was all mechanical. I had no sense of history and I had no feel. Money was easy before that date, so I figured that I knew all that I had to know. After feeling the panic of a drop, the relief of selling, and the disillusionment of witnessing stocks rebounding after I sold, I was mentally and emotionally drained. Like the young lawyer above, my strategies and account were one disjointed mess. I realized that I really didn't know much about the market, maybe I was ready to learn.

Last week, I began to discuss some of the lessons that I learned in the carnage of those two days. Please refer to the October 10th, 2000 Options 101 article. Those lessons dealt with stock selection. Below are additional lessons that I learned. Some of these lessons are personal in as much as they fit within my personal time constraints and may not be applicable to the full time trader.

5. DO NOT USE MARGIN. Simply put, margin makes you a victim. When the market moves against you and you are margined, fear and panic grip you. You can lose your objectivity, because your lifestyle is affected. You begin to hope, then panic. Worse yet, you may get a maintenance call from your broker. This requires you to pony up money immediately or suffer a forced sale which usually happens at the market bottom and just before a reversal. Instead of using margin on the front end, save some cash to use to buy the severe dips. Someone else's margin call can be your buy of the year. Use the dips to make great buys, do not allow the dips to wreck your account.

6. DO NOT BUY FRONT MONTH CALLS UNLESS YOU CAN MONITER THE ACTION ON AN HOURLY BASIS. In case you haven't noticed, this market turns on a dime. Who knows what will happen next hour much less the next day. Front end options can depreciate instantly. At least with stocks, you have the luxury of selling for a loss or waiting for a rebound. With front end options, you can lose it all quickly. This obviously affects your psyche and objectivity. When objectivity is lost, anyone can and will make silly and desperate decisions.

7. SAVE SOME CASH FOR RAINY DAYS. This rule is consistent the above rules. When you have some cash set aside, downturns can turn into buying opportunities instead of margin calls. When you have some cash set aside, you can take positive action to enhance your account, rather than sit by helplessly watching your account shrink.

8. DO NOT PLACE TOO MUCH MONEY INTO ANY ONE STOCK. Although It is tempting, try to avoid placing too much money into any one stock. Just one week ago the market rallied 250 points, but EXTR fell 12 points despite blowout earnings. EXTR is a great stock, but it did not act great that day. PMCS and CHKP offset the EXTR loss. Needless to say, it is better to divide your risk.

9. HAVE AN OVERALL PLAN. I wrote this article last week, so I do not have the benefit of knowing what happened on Monday or today. If the market is doing well, no doubt you feel euphoric. If the market is down, fear is in the air. If you have a plan, you feel neither euphoric or fearful because you realize that over the long haul there will be great times and bad times in the market. You simply have to learn to execute in all environments. Personally, in my IRA account I am more patient with each stock when they fall because I am convinced of their overall quality. In my cash account, I try to generate a monthly income, so I typically write covered calls most of the time.

I do not represent myself as any expert. In fact my conservative money management is employed because I recognize my inadequacies. I am in this game over the long haul, so I can not let the August 31st's of the market break me. Like any other storm of life, they must be confidently and adequately managed.

Options 101 Archives